Thursday, July 30, 2009

"This paper finds no evidence that speculative activity in futures markets for industrial metals caused higher spot prices in recent years. The empirical analysis focuses on industrial metals with and without futures contracts.....

...comovement between metals with and without futures contracts has not weakened in recent years as speculative activity has risen.....This comovement is driven by economic fundamentals because world GDP growth is strongly correlated with metal price growth, especially after 2002. The structural change in 2002 is also consistent with supply and demand information found in industry newsletters.....

...final test follows storage models, which suggest that speculation can affect spot markets only if it leads to physical hoarding. Focusing on metals with established futures markets, I find no evidence of physical hoarding because inventory growth is found to be negatively correlated with price growth rates."

A few questions remain unanswered to me, but very interesting. This topic has been in the news a great deal lately.

Wednesday, July 29, 2009

"The bill does not set pay limits. Instead, it gives shareholders the right to vote on pay and requires that independent directors from outside of management serve on compensation committees.

The shareholder votes would not be binding on company management.

The measure tries to reduce the potential conflicts of interest involving compensation consultants who play a central role in blessing pay packages. Many of those consultants also provide other services to the companies, putting them in a conflicting role for issuing fairness opinions about pay."

As a part time landlord, I will definitely agree with this this one. I am not sure the reason, but rent prices take much longer to adjust than do real estate prices. Now we have 355 years of data (amazing btw) to back up that statement.

"This paper examines the long run relation between prices and rents for houses in Amsterdam from 1650 through 2005. We first demonstrate that these series are cointegrated, a necessary condition for studying movements of the rent-price ratio. We then estimate the deviation of house prices from fundamentals and find that these deviations can be persistent and long-lasting. Lastly, we look at the feedback mechanisms between housing market fundamentals and prices, and find that market correction of the mispricing occurs mainly through prices not rents. This correction back to equilibrium, however, can take decades"

"'Like Einstein, we used to think we could describe Brownian motion with a standard bell-shaped curve,' Granick said. 'But now, with the ability to measure very small distances much more precisely than was possible 100 years ago, we have found that we can have extremes much farther than previously imagined.'

....there were many features in full agreement with Einstein and the bell-shaped curve; but there were also features in significant disagreement. In those cases, the beads moved much farther than the common curve could predict. In those extreme displacements, diffusion behavior was not Gaussian, the researchers report. The behavior was exponential.

"These large displacements happen less often, but when they do occur, they are much bigger than we previously thought possible," Granick said."

"Federal Reserve Chairman Ben Bernanke on Sunday said he engineered the central bank's controversial actions over the past year because 'I was not going to be the Federal Reserve chairman who presided over the second Great Depression.....

And later:

"Mr. Bernanke responded that "nothing made me more frustrated, more angry, than having to intervene" when firms were "taking wild bets that had forced these companies close to bankruptcy."

More than 20 people asked questions...on topics ranging from bailouts to mortgage-regulation practices to the Fed's independence....Mr. Bernanke suggested that a movement by lawmakers to open the Fed's monetary-policy operations to audits by the Government Accountability Office is misunderstood by the public....

So can Lance turn their fortunes around? What does the market think? There was no impact on the announcement of the deal (12:00 on Thursday) which was timed to correspond with the finish of the final time trial stage of the Tour de France.

BUT then yesterday it was up over 10%. There was news on the day: an upgrade and a new deal with T-Mobile that may have affected it. Or was it that small investors (cyclists?) take more time to trade? Only time will tell.

Here is a finance article (ok, at least a business article) from Bicycling.com that addresses some of the same issues.

"But the upsides aren’t quite as crystal clear for RadioShack. The company’s fortunes have been slowly sagging - along with its stock price - for almost a decade.

The stock itself peaked at $76.62 a share in November…of 1999....It trades now for $14.67 per share. That’s up over 100 percent from a March 9 low of $6.47, but well below its last peak, in June 2007, at over $34 a share.

....But stock prices and short interest are not the problem; rather, they represent the real problems the company faces.

For years, RadioShack has had an image as a somewhat dowdy retailer of necessary but unsexy items, including a whole roster of small electronics components whose purposes are dimly understood outside of a small subset of tinkerers."

Don't bet against Lance

As we've seen first when he came back from cancer to win 7 tours, and then again this year when he showed not only great marketing savvy and a strong base of support (he has over a million followers on Twitter alone) but also amazing determination when he came back from a three year absence AND a broken collarbone as one of the oldest riders in the Tour to get a podium finish (which he basically assured less than an hour ago on the slopes of Mont Ventoux), most people do not get rich betting against Lance.

Either way it will be a great case study (for marketing if not finance) to follow. Stay tuned!

Asymmetric and short-term oriented pay packages have largely been seen as major causes of the financial meltdown we saw last year. So since everyone has seen the problems, we are no longer going to pay people in the same manner. Right? Well, hold on, not so fast.

"Goldman posted the richest quarterly profit in its 140-year history and, to the envy of its rivals, announced that it had earmarked $11.4 billion so far this year to compensate its workers. At that rate, Goldman employees could, on average, earn roughly $770,000 each this year — or nearly what they did at the height of the boom."

Now it should be noted, that the firm has not said what they are doing with all of this money that is being set aside, but it does seem like a potential problem.

"...if Goldman proceeds to pay record cash bonuses this year, as many now expect, these payments would reflect a return to flawed pay structures, as well as a failure to implement effectively the compensation principles Goldman recently put forward....The crisis has highlighted a substantial flaw in compensation structures that provide rewards for short-term performance – which is what Goldman’s paying super cash bonuses for 2009 would do. Such rewards can over-compensate executives as well as produce excessive incentives to take risks."

On the same theme later:

"The short-term distortion caused by standard compensation structures, ...highlighted in our “Pay without Performance” book, has recently become widely accepted. Treasury Secretary Geithner stated last month that “[s]ome of the decisions that contributed to this crisis occurred when people were able to earn immediate gains without their compensation reflecting the long-term risks they were taking for their companies and their shareholders.”"

What can be done? Bebchuk suggests a partial solution that is being used by some firms:

"At a minimum, even if some bonuses are based on 2009 results alone, Goldman would do well to prevent the immediate cashing out of these bonuses....any 2009-based amounts should be parked in a company account for an extended period of time and adjusted downward if subsequent information indicates that the basis for the bonuses no longer holds up."

This piece brings to mind two cliches which I will allow the reader to apply as needed:

Ok, before I get fired, let me explain. Naked trading is when a speculator trades a derivative security without a position in the underlying asset. For instance, if I were to short a corn futures contract, I would be "naked" since I do not own corn to sell. So prior to settlement I either have to buy back the contract or purchase corn to cover the trade. (The other type of position is covered which is when you do own the underlying asset).

"A ban on “naked” trading in the $26.4 trillion credit-default swaps market being considered by U.S. lawmakers would have the unintended consequence of making it more expensive for companies to borrow, traders said...."

more from the article:

"Credit-default swaps were created as a way for corporate lenders and bondholders to protect themselves from defaults. Naked swaps, where the investor doesn’t own the debt on which the contracts are based, have proliferated in the market and may be prohibited under legislation being drafted by House Financial Services Committee...."

Why?

"Credit-default swaps were used by American International Group Inc. to bet on residential mortgage debt, driving the insurer to the brink of bankruptcy when it couldn’t come up with collateral as prices plunged, and regulators have blamed the market for exacerbating the financial crisis. "

additionally many have argued that naked Credit Default Swaps create an misaligned incentives. Some have compared them to buying life insurance on another person. If you buy too much you might have the incentive to hire a local hit-(wo)man.

"The obvious reason for limiting my capacity to take out insurance on the life of a complete stranger (whose life presumably has little intrinsic value for me) is moral hazard - what I will call micro-level endogenous risk. If the stranger’s life is insured for a sufficiently large amount, and if I can overcome the internal resistance of conscience and ‘thou shalt not kill’, I could arrange to have the highly insured stranger bumped off. When the probability of the insured-against contingency occurring is not exogenous, but can be influenced by the party purchasing the insurance, and if this cannot be verified and deterred by the party selling the insurance or by the forces of law and other and of contract enforcement, we have moral hazard."

If the position is great enough a naked CDS position would create a similarly bad moral hazard problem.

So what is the cost associated with banning naked trading?

CDS are not all bad. They do allow banks to offset default risk. They thus make borrowing easier and cheaper.

If naked trading forbidden, the ban would almost assuredly reduce liquidity and thus make it costlier for lenders to offset default risk.

"...making it costlier for investors to hedge their stakes, said Robert Pickel, chief executive officer of the International Swaps and Derivatives Association, a New York-based industry group that sets rules and guidelines for the market....“Having people who are in there speculating adds liquidity and depth to the market so that anybody who is a pure hedger,...can tap that market and know they have a deep and liquid market...."

To turn back to the corn example, suppose that only farmers and large corn consumers ("bakers" in a typical in class example) were in the market. When a farmer went to trade, there might not be a liquid market so (s)he may end up selling at a lower price (of course it also works the other way and the baker may end up paying more). This makes hedging more expensive, and at the margin, would be likely lead to fewer farmers hedging which would be expected in the long run lead to fewer farmers period, and hence more expensive corn.

This is a particularly important issue since most participants in the Credit Default Swaps market are naked.

"As much as 80 percent of the credit-default swap market is traded by firms that don’t own the underlying debt, Eric Dinallo, the former superintendent of the New York State Insurance Department, estimated in a January interview."

"Mr. Buffett’s stake in Goldman is now worth $9.1 billion, or about $4.1 billion more than what he paid 10 months ago, according to an analysis by Linus Wilson, an assistant professor of finance at the University of Louisiana at Lafayette.

According to Mr. Wilson’s calculations, Mr. Buffett would realize an annualized return of about 111 percent if he sold his Goldman stake, which is held by his conglomerate Berkshire Hathaway.

In comparison, the federal government received a 23 percent annualized return for its Goldman investment, the bank said after it agreed on Wednesday to pay $1.1 billion to settle warrants the Treasury Department received after injecting $10 billion into the bank in November."

And added bonus in this article is it briefly discusses how to value warrants (price the option but realize you must adjust dilution).

"Wilson...ascribed a $5.5 billion valuation to Mr. Buffett’s preferred shares and $3.2 billion to the warrants.... The valuation of the warrants was based on Goldman’s closing share price of $160.46 on Wednesday and the 10-year historic volatility of the shares. (For financial wonks, Mr. Wilson used the Black-Scholes and Merton option pricing models with the dilution adjustments of Galai and Schneller.)

BTW I am currently ristening to Snowball and definitely recommend it. I have been amazed at how similar the Goldman deal was to his Salomon deal back in the early 1990s. The book is well done financially (talks about Junk Bonds days, takeovers, spin-offs, etc) and I have learned a great deal about Buffett.

It also has good "class examples" and trivia. For instance, did you know that Warren owned a farm while in High School? Or that when growing up he considered the cost of an item not how much it cost now, but what he would be giving up in the future after the money grew--I mention that since I used to do that too. Alas the similarities stop before getting to my wallet. lol.

Total Disclosure: BonaSIMM (to which I am the faculty leader) has a stake in Goldman. It is however, a bit smaller than Mr. Buffett's.

"It’s been a tough season for the proposition that “microfinance is a proven and cost-effective tool to help the very poor lift themselves out of poverty and improve the lives of their families.” In May came a randomized trial of microcredit in Hyderabad finding no impacts on poverty 15–18 months out. In June came a paper challenging the leading older-generation studies that seemed to show that microcredit had cut poverty in Bangladesh in the 1990s. Now in July we have another randomized trial, of microcredit in Manila, also finding no impact on bottom-line measures of household welfare.

A couple of people, including Tim Ogden, have raised a good question with me in the last few days: What does this mean for microfinance? Has a myth been debunked? Is the whole movement about to implode in a ball of fire? More precisely, will this research perturb the dominant narrative about microfinance in the public mind, about microenterprise as a reliable ladder out of poverty?"

Roodman had written back in June a piece called "Why I Doubt Most Microfinance Impact Studies" in which rightly criticizes all of the studies on theoretical grounds. He begins by talking about studies about foreign aid helping or not helping and then explains that the same logic can be used on Microfinance studies.

"These studies were not randomized: no government has ever experimentally given lots of aid to some countries while randomly withholding it from others. One major shortcoming in these papers, which I defined in the post on which Asif commented, is data mining. Non-randomized studies are more prone to it. Another is the difficulty of going beyond correlation to prove causation....

All of these concerns apply to the academic studies done over the last two decades of the impacts of microcredit on families and businesses. "

So where does this leave us? Pretty much back where we started. Still waiting for definitive research but cautiously optimistic that by increasing the financing alternatives, the poor are made better off.

...empirical analysis focuses on some beliefs associated with eclipses, phenomena that are typically interpreted as bad omens by the superstitious both in Asian and Western societies, and we employ a dataset containing 362 such events over the period 1928-2008. Using four broad indices of the U.S. stock market, we uncover strong evidence in support of our superstition hypothesis in four distinct ways. First, the occurrence of negative superstitious events (i.e. eclipses) is associated with below-average stock returns, which is consistent with a diminished buying pressure coming from the superstitious. Second, the size of the superstition effect is estimated to increase in times of high market uncertainty and when eclipses draw wide media coverage and public attention. Third, the negative performance of the market during the superstitious event is followed by a reversal effect of similar magnitude (10 basis points per day) on the subsequent trading days. Fourth, eclipses are accompanied by a trading volume decline. When we extend our analysis to a sample of Asian countries, we find analogous results. The patterns we document are inconsistent with the Efficient Market Theory, as eclipses are perfectly predictable events."

" Now however, everything has changed because we here at Political Calculations are putting the entire encapsulated history of the S&P 500 at your fingertips!

We've taken the raw data from the sources linked above, and made it easily accessible by selecting a month and year in our tool below. The tool will provide the average index value of the S&P 500 for the given month and year, the associated dividends and earnings for that month and year, not to mention the dividend yield and the price to earnings ratio. For good measure, we threw in the value of the Consumer Price Index as well!"

2. How much an investment would have grown from and to any point in time from 1871 (yeah, so the data may not be perfectly clean, still a good look!)

"All you need to do is to select the dates you want to run your hypothetical investment between and to enter the amount of money to invest either from the very beginning or to add each month (beginning with that first month you select) for the duration that your investment runs.

We'll determine how much your investment would be worth assuming the amounts invested are adjusted for inflation for each month the investment is active and accounting for the effects of either not reinvesting dividends along the way or fully reinvesting dividends"

What is PoliticalCalcuations? From the site: "Welcome to the blogosphere's toolchest! Here, unlike other blogs dedicated to analyzing current events, we create easy-to-use, simple tools to do the math related to them so you can get in on the action too!"

Great stuff!

Update.

Of course all data should come with a warning on its use. Zvi Bodi provides us one

"You should caution readers that the historical data on stock returns is being misinterpreted to imply that stocks are not risky in the long run....This is misleading and invalid. The figure merely illustrates that the dispersion (standard deviation) of an N-period average rate of return declines as N increases."

Tuesday, July 21, 2009

"Behavioral Finance is a relatively recent revolution in finance that applies insights from all of the social sciences to finance. New decision-making models incorporate psychology and sociology, among other disciplines, to explain economic and financial phenomenon, such as erratic stock price variations. Psychological patterns such as overconfidence and perceived kinks in the value function seem to impact financial decision-making, but are not included in classical theories such as the Expected Utility Theory. Kahneman and Tversky's Prospect Theory addresses such issues and sheds light on irrational deviations from traditional decision-making models."

"It is a mainstream view that the Fed has failed to foresee and prevent the crisis, that it has managed it ineffectively since it started, and that it has allowed itself to be used as a quasi-fiscal instrument of the US Treasury, by-passing Congressional control. Are any or all of these criticisms justified? Let’s ponder a few of them."

He then goes on to show that the Fed and many others missed the crisis until it was too late. SO sure the Fed deserves some of the blame but so too do others.

On regulation's failure:

"...the whole mishmash of US financial regulation and supervision has long been viewed as a school book example of how not to structure such activities. Fragmentation, balkanisation, overlap, turf battles and unproductive inter-agency rivalry and jealousy are the name of the game. With federal commercial banking supervision split between the Fed, the FDIC and the Controller of the Currency (not counting the Office of Thrift Supervision for federal savings banks) and investment banks (not) supervised and regulated by the SEC, the US regulatory framework was an accident waiting to happen. Federal securities markets regulation and supervision is, for no good reason, split between the SEC and the Commodity Futures Trading Commission. The SEC - discredited and without its investment bank constituency - is an organisation begging to be put out of its misery."

and on the Fed now:"

"The Fed has been actively contributing to the next crisis

Here indeed the Fed stands guilty as charged, although it is in good company. The Fed, through its lender of last resort and market maker of last resort actions and through a wide range of quasi-fiscal support operations it has undertaken on behalf of Wall Street and other segments of the US financial establishment (Fannie & Freddie, AIG), has made a major contribution to the creation of the biggest moral hazard machine ever seen in human history."

There are many other great points left out here, but the conclusion is worth pointing out for those of you who do not click through:.

"If the same institution, the central bank, has to be in charge of both normal monetary policy and systemic risk regulation (albeit jointly with the Treasury for the systemic risk role), there is no elegant, first-best solution. Either monetary policy will be driven by politicians whose macroeconomics is limited to a partial understanding of the Keynesian cross and whose monetary policy views can be summarised by the proposition that the have never seen an official policy rate so low they would not want it even lower, or the central bank continues to act as an off-budget, off-balance sheet special purpose vehicle of the Treasury."

Cutting through all of the very important stuff before (who is to blame, what went wrong, etc etc etc), the whole article is worth it if you only read and understand that conclusion.

"...in the wake of last fall’s stock market collapse, fully embracing the efficient market hypothesis can be a scary proposition – a bit like stepping out on “the Ledge” at Willis Tower. (An absolute must if you’re in Chicago, by the way.) The events of the past year have sparked a rich debate between behavioral economists and EMH-ers over the the EMH’s validity that is nicely chronicled in this week’s Economist.

“In some ways, we behavioural economists have won by default, because we have been less arrogant,” says Richard Thaler of the University of Chicago, one of the pioneers of behavioural finance. Those who denied that prices could get out of line, or ever have bubbles, “look foolish”. (Myron) Scholes, however, insists that the efficient-market paradigm is not dead: “To say something has failed you have to have something to replace it, and so far we don’t have a new paradigm to replace efficient markets.” The trouble with behavioural economics, he adds, is that “it really hasn’t shown in aggregate how it affects prices.”

An absolute "must-read" for my Behavioral Finance class! Going on the syllabus.

Sunday, July 19, 2009

"That is how innovation often proceeds — by learning from errors and hazards and gradually conquering problems through devices of increasing complexity and sophistication."

then

"We need consumer products that people can use properly, and if this is what “plain vanilla” means, that’s a good thing. But we also need financial innovation that responds to central problems. The effectiveness of our free enterprise system depends on allowing business people to manage the myriad risks — including the risk of asset bubbles — that impinge on their operations in the long term."

and later (near the end)

"Complexity is not in itself a bad thing. It is, in fact, a hallmark of modern civilization. A laptop computer is an immensely complex instrument, with trillions of electronic components, and almost none of us can explain what goes on inside it. Yet it can be designed well so that it seems plain vanilla to the ultimate user."

While I like the analogy to the steam engine it breaks down somewhat since James Watt used self constraint and did not use high pressure until it could be safely used. That said the rest of the article, and the analogy itself, is excellent.

(I confess at some levels this "plain vanilla" talk battle reminds me the battle over Riordan Metal early in Atlas Shrugged)

Update:

For a slightly differing view (one that says that the complexity was not needed and harmful and essentially just a means to "rip off" others, see this SeekingAlpha article.

"The June issue of Gregor.us Monthly, The Scholarship of Collapse, addresses several views of economic and systemic collapse from the works of Jared Diamond to Joseph Tainter, and then goes on to apply these views to the United States–and to its biggest state, California....Ouch. Permanently smaller economy!? Are you kidding me? The United States? Yeah, I know. The growth paradigm since WW2 is so firmly entrenched in the record (and in the psyche) that mere mention of US economic stasis seems outlandish. To suggest, as I am, that this condition will carry on for years sounds impossible. However, that is my call. I now foresee zero, net physical infrastructure or housing growth in California for at least another 5 years. If housing units go up somewhere in California, they’ll be bulldozed someplace else. If new roads or highways are erected, they’ll be discontinued or dismantled somewhere else. Without California, there will be no sustainable US GDP growth."

Believe it or not, it gets worse (as in more depressing) from there.

One more look in:

"The United States, just like California, now sits astride massive, gargantuan post-war infrastructure that was built with cheap energy and leveraged with cheap energy, for over 50 years. Many parts of the US right now are actually experiencing something closer to a depression,...The United States has been in an inflationary recession since the start of the decade, which now threatens to become an inflationary depression. To make matters worse, the federal government is in the midst of one of the largest policy mistakes in US history as it has chosen to make enormous new investments in car companies, cars, biofuels, roads, and highways to the exclusion of public transport. This is a classic, textbook example of the sunk cost effect in decision making and is a hallmark of the collapsed societies of antiquity."

And while I may not agree with all of this, it is definitely a possibility and being aware of it will make it less likely.

HT to @BionicTurtle for pointing this one out. (I am really looking forward to the BionicTurtle who just joined twitter. Check out his channel on YouTube or BionicTurtle.com.

"Calpers maintains that in giving these packages of securities the agencies’ highest credit rating, the three top ratings agencies — Moody’s Investors Service, Standard & Poor’s and Fitch — “made negligent misrepresentation” to the pension fund, which provides retirement benefits to 1.6 million public employees in California.

The AAA ratings given by the agencies “proved to be wildly inaccurate and unreasonably high,” according to the suit, which also said that the methods used by the rating agencies to assess these packages of securities “were seriously flawed in conception and incompetently applied.”

and later:

"While the lawsuit is not the first against the credit rating agencies, some of which face litigation not only from investors in the securities they rated but from their own shareholders, too, it does lay out how an investor as sophisticated as Calpers, which has $173 billion in assets, could be led astray.

The security packages were so opaque that only the hedge funds that put them together...and the ratings agencies knew what the packages contained. Information about the securities in these packages was considered proprietary and not provided to the investors who bought them.

Calpers also criticized what contends are conflicts of interest by the rating agencies, which are paid by the companies issuing the securities — an arrangement that has come under fire as a disincentive for the agencies to be vigilant on behalf of investors.

"...the bank announced its third sweep of top management in less than a year, elevating John C. Gerspach, the chief accounting officer, to Mr. Kelly’s post, and reeling in an experienced outsider, Eugene M. McQuade, to sharpen its focus on traditional banking in response to concerns from Washington.

The shakeup highlights the uncertainties Citigroup still faces months after accepting three multibillion-dollar government bailouts"

and later:

"Citigroup has now had five chief financial officers in five years, and senior managers keep leaving. A Barclays Capital report of the bank found that just 17 of Citigroup’s 43 highest ranking executives in 2006 remain at the company. "

So at least at some level, it does seem that those who allowed the troubles to occur are paying a penalty for their actions (or lack thereof).

And then the other reason for this inclusion is to point out that Eugene McQuade went to St Bonaventure!

"Dr. Lo and his staff use futures and forward contracts to invest in the stock, bond, commodity and currency markets.

His move into money management and mutual funds isn’t without risks....Plenty of professors have flopped on Wall Street, calling into question whether their theories amounted to more than elegant math. Two Nobel laureates worked with Long-Term Capital Management, which nearly collapsed in 1998....And many mutual funds in general, despite their potential on paper, fail to deliver market-beating returns.

From September through June, Dr. Lo’s fund...returned 0.19 percent, versus a 20 percent decline in the Standard & Poor’s 500. The fund’s expense ratio was 1.62 percent, versus an average of 2.10 percent for comparable offerings tracked by Morningstar.

Lo described the need for the fund:

“Investors...have suffered from diversification-deficit disorder,.....They think they’re getting diversification from putting their money in large- and small-cap stocks, value and growth strategies and international and emerging markets. But the fact is that all of those went down last year.”

His prescription ...hedge fund beta replication....Mathematical models discern the common bets that hedge funds have made — their betas, in technical terms. AlphaSimplex uses futures and forwards to replicate these betas. By design, the method aims to capture the average risk and return of a diversified portfolio of hedge funds.

Tuesday, July 14, 2009

Lost in the fear of inflation that has gripped many for months, is the reverse and almost silent bull market killer, deflation. In recent days however we have seen that deflation has again made the news.

"Ireland sunk further into deflation in June as the cost of living fell at the fastest rate since the Great Depression, raising the prospect of a prolonged recession"it is deflation that is the problem.

Most of us know the traditional (and well documented) truth that higher money supply growth leads to inflation rule. How can their be deflation with such a growth in the money supply?

There is no simple answer but when you couple the fact that banks are not making as many loans as they did previously and consumers are not buying as much as they did previously, you have at least the right conditions for deflation.

To make matters worse, the money being spend under the Fed stimulus packages may not be having as large of impact as had been hoped/expected. For instance consider the following article that Charlie a former student of mine sent:

"...week, the most important question that an investor can ask is whether we are in for deflation or inflation. And this week we read a well reasoned piece on deflation. ...Van Hoisington and Dr. Lacy Hunt give us a few thoughts on why they think it is deflation that will ultimately be the problem and not inflation we are dealing with today....

...Barro and Perotti are saying that each $1 increase in government spending reduces private spending by about $1, with no net benefit to GDP. All that is left is a higher level of government debt creating slower economic growth."

"....a paper written at the University of California Berkeley entitled The Macroeconomic Effects of Tax Changes: Estimates Based on a new Measure of Fiscal Shocks, by Christina D. and David H. Romer (March 2007). (Christina Romer now chairs the president's Council of Economic Advisors). This study found that the tax multiplier is 3, meaning that each dollar rise in taxes will reduce private spending by $3."

So what do you think? Inflation? Or Deflation.

This is the new poll question I included on the blog: which is more likely Inflation or Deflation?" It's off on the left. Right now Inflation is ahead 58% to 42%.

And if you are not confused enough, one scenario worth considering is short term deflation (due to lower demand), and then longer term inflation (due to higher money supply growth) when the Fed has a difficult time withdrawing money from the system.

"A study that appeared in the September 2007 issue of the Journal of Banking and Finance has found that poor market-timing decisions are the rule rather than the exception. Titled “Mutual Fund Flows and Investor Returns: An Empirical Examination of Fund Investor Timing Ability,” its authors are Geoffrey C. Friesen, a finance professor at the University of Nebraska, Lincoln, and Travis R. A. Sapp, a professor of accounting and finance at Iowa State University.

The professors analyzed investors’ behavior at all domestic equity funds from 1991 through 2004. They found that investors’ poor timing decisions reduced their average returns over this period by 1.6 percentage points a year."

BTW the Friensen and Sapp go one step further in another paper (teaming with Mercer Bullard) and find that those investors who deal with load fund (vs no load funds) have are even worse at market timing. This flies in the face of the view that financial professionals have added timing benefits.

Monday, July 13, 2009

Bogle is a great presenter and this definitely does not disappoint. VERY good. It will definitely be used for classes dealing with governance and even financial institutions.

The Bogle piece that I used here is part of a longer (1:27) presentation on the crisis. The entire thing is worth the effort, but I am biased and liked Bogle's the best. Why biased? Possibly because one of the best presentations I have ever seen was by John Bogle in Rochester a few years ago. The ideas he railed against then (agency costs and transaction while calling for better transparency and governance), really were driving forces behind the current problems.

"Findings from behavioral organization theory, behavioral decision theory, survey research, and experimental economics leave no doubt about the failure of rational choice as a descriptive model of human behavior. But this does not mean that people and their politics are irrational. Bounded rationality asserts that decision makers are intendedly rational; that is, they are goal oriented and adaptive, but because of human cognitive and emotional architecture, they sometimes fail,occasionally in important decisions."

Aswath Damodaran from NYU is truly one of the best professors I have ever seen--a true genius. He is one of a handful of financeprofessors I will drop everything to see his presentation at any conference.

"Professor Aswath Damodaran, Professor of Finance from the New York University Stern School of Business, lectures about stock buybacks and dividends. See http://pages.stern.nyu.edu/... for more. ."

Quote of the video?

"Dividends are like getting married, stock buybacks are like hooking up."

This class video is from 2007 but it so well done I will include it.

BTW I found this when I was deciding on a new idea for class. I want to do 5 minute (preview/summary) for the most important things in class. (The same video can serve as both preview to help create the mental architecture on which to "hang" the class material and a summary to help students reinforce the key points of the class. (Any thoughts, from either students or professors would be appreciated.)

Friday, July 10, 2009

"Geithner's plan calls for greater reporting, capital, leverage and disclosure standards for all derivative traders and dealers, but some lawmakers are seeking to have these specialized derivatives cleared through more transparent clearinghouses, which serve as an intermediary between buyers and sellers in transactions"

Thursday, July 09, 2009

Have you noticed that the plans to buy the so called toxic assets to spur more lending has not caught on? Harvard's Lucian Bebchuk gets to the heart of the matter in today's WSJ. EXCELLENT Piece that it well worth reading.

Short version?: Due to changes in accounting and regulatory practices, banks have no incentive to sell off their bad loans. So guess what? They aren't. They are holding assets on the books that are worth less than their financial statements say. This could prolong the downturn.

"The plan for buying troubled assets — which was earlier announced as the central element of the administration’s financial stability plan — has been recently curtailed drastically. The Treasury and the FDIC have attributed this development to banks’ new ability to raise capital through stock sales without having to sell toxic assets. But the program’s inability to take off is in large part due to decisions by banking regulators and accounting officials to allow banks to pretend that toxic assets haven’t declined in value as long as they avoid selling them."

and later:

"The problem, however, is that banks now have strong incentives to avoid selling toxic assets at any price below face value even when the price fully reflects fair value.

A month after the PPIP program was announced, under pressure from banks and Congress, the U.S. Financial Accounting Standards Board watered down accounting rules and made it easier for banks not to mark down the value of toxic assets....

As long as banks don’t sell, the policies enable them to pretend, and operate as if, their toxic assets maturing after 2010 haven’t fallen in value at all.

Bebchuk points out that we will get a sneak peak at the true value of these assets:

"While the market for banks' toxic assets will remain largely shut down, we are going to get a sense of their value when the FDIC auctions off later this summer the toxic assets held by failed banks taken over by the FDIC. If these auctions produce substantial discounts to face value, they should ring the alarm bells."

The article concludes:

"...it must be recognized that the curtailing of the PIPP program doesn't imply that the toxic assets problem has largely gone away; it has been merely swept under the carpet."

On the first week of almost any introductory finance class the professor will begin off the lecture with a discussion of why cash flow matters more than accounting based numbers that depend on assumptions and choices that are often influenced by agency cost problems and a desire to abide by various loan covenants and even public opinion. Depending on the class, the discussion might then explain the difficulties in actually getting cash flow numbers.

"If banks more consistently accounted for their operating cash flow, companies could gain a better grasp of their commercial banks' financial health, two professors suggest in a report to be released later this week.

The results would be astoundingly different than what financial institutions' statements of cash flows tell us today. In the course of an attempt to make the firms' cash-flow reports more comparable - which entailed several adjustments to how banks classified their investments, accounted for non-cash transfers of their loans, and recorded cash flow from acquisitions last year - the researchers saw huge swings, both downward (Bank of America) and upward (KeyCorp)."

Tuesday, July 07, 2009

"'Your timing has to be perfect,' says David Jones, former Fed economist and president and CEO of DMJ Advisors LLC in Denver. 'If you do it too soon, you keep us in a deep recession. And if you do it too late, you get inflation.'"

"The focus on subprimes ignores the widely available industry facts (reported by the Mortgage Bankers Association) that 51% of all foreclosed homes had prime loans, not subprime, and that the foreclosure rate for prime loans grew by 488% compared to a growth rate of 200% for subprime foreclosures."

and later

"...the important factor is whether or not the homeowner currently has or ever had an important financial stake in the house. Yet merely because an individual has a home with negative equity does not imply that he or she cannot make mortgage payments so much as it implies that the borrower is more willing to walk away from the loan."

and later yet:

"...stronger underwriting standards are needed -- especially a requirement for relatively high down payments. If substantial down payments had been required, the housing price bubble would certainly have been smaller, if it occurred at all, and the incidence of negative equity would have been much smaller even as home prices fell"

While dramatically oversimplified this does bring a very good point to light: namely that as other countries improve their transparency and governance, the US dollar loses its relative advantage. There is more to the article, but the below quote catches the flavor well.

"...what's the real reason to fear a dollar decline? It's that governments around the world are more stable and transparent than they used to be, meaning more currencies are worth 'holding in the mattress.' It still is, for the most part, that no matter where you are, it makes sense to hold some US Dollars as a reliable store of value. But maybe now you'll carry some Brazilian Real or Singapore Dollars. Basically, the real issue is current and growing Dollar competition, a trend that doesn't look likely to abate."

".....Things become much more complex in the world of irrationality. Much of traditional economics becomes outmoded when complex relationships based on often counter-intuitive behaviors are taken into account. Instead of a management philosophy centered around the manager as the play-caller, assigning tasks and motivating people to carry them out, we are told by the neuroscientists that the new management job is one of facilitating more of a customized, do-it-yourself process centered around each newly-energized employee, one centered on questions (often leading) rather than direction."

"Here's a dilemma: You manage a public employee pension plan and your actuary tells you it is significantly underfunded. You don't want to raise contributions. Cutting benefits is out of the question. To be honest, you'd really rather not even admit there's a problem, lest taxpayers get upset.

What to do? For the administrators of two Montana pension plans, the answer is obvious: Get a new actuary. Or at least that's the essence of the managers' recent solicitations for actuarial services, which warn that actuaries who favor reporting the full market value of pension liabilities probably shouldn't bother applying.

....The numbers are worse using market valuation methods (the methods private-sector plans must use),.... Using that method, University of Chicago economists Robert Novy-Marx and Joshua Rauh calculate that, even prior to the market collapse, public pensions were actually short by nearly $2 trillion. That's nearly $87,000 per plan participant. With employee benefits guaranteed by law and sometimes even by state constitutions, it's likely these gargantuan shortfalls will have to be borne by unsuspecting taxpayers."

Friday, July 03, 2009

"Major League Baseball within the last week loaned millions to Tom Hicks, the evidently cash-strapped owner of the Texas Rangers, and will continue to offer financial assistance to Hicks until he is able to sell the team

.....The Rangers’ opening day payroll this season was around $68.1 million, which ranked 22nd among MLB’s 30 teams and was less than $1 million more than its 2008 level."

Two angles you could take on this in a class that would surely spark some conversations:

1. The league has a vested interest that a team does not go under. This is one reason they have requirements to buy a team and for salary caps. Are there any similarities with the banking sector? (Brings back old lessons on Reg Q).2. Financing (and the lack thereof) can negatively impact operations.

"Ken Schneider, an options trader at New York-based environmental hedge fund RNK, said investors are buying put options on speculation there will be new restrictions on United Nations’ Certified Emission Reduction credits. Polluters can now use the UN’s so-called offset credits from projects in less- developed nations to meet European Union requirements to reduce carbon dioxide emissions. Restrictions on their use may slash their value.

“The Certified Emission Reductions are a keg of dynamite in a matchstick factory,” Schneider....

and later:

..."buyers paid about 3.25 euros ($4.57) a ton last week for 5 million tons of 2012 Certified Emission Reduction puts with a strike price of 10 euros a ton, according to data from the European Climate Exchange in London. Today’s closing price for 2012 CERs was 12.43 euros a ton, up 2.1 percent compared with June 26."

Wednesday, July 01, 2009

"The effort of congressmen to uphold the distinction between the public and private sectors is noble, and doomed to fail in this case. Last week's hearing reflected unmedicated unease over two facts legislators recognize but resist acknowledging: There is no practical solution to 'too big to fail,' and no alternative to the Fed's ability to print money to ease potentially destabilizing financial panics.

Governments long ago authorized banks to operate with capital and reserve requirements inadequate to cover serious panics, with the understanding that government would step in. 'We have chosen capital standards that by any stretch of the imagination cannot protect against all potential adverse loss outcomes,' Alan Greenspan explained in a talk at the American Enterprise Institute this month. 'Implicit in this exercise' is the occasional bailout of the financial system."

"Does it make sense to dollar cost average? It depends. Standard financial analysis says dollar cost averaging is suboptimal. If you focus on only your investment outcome, investing a lump sum immediately lets you construct the best portfolio you can today; slowing the process with dollar cost averaging just keeps you in something other than your best portfolio until you are done. Behavioral finance provides a different perspective."